Over the last several years, as cryptocurrencies like Bitcoin and Ethereum have become popular, thousands of groups of developers have attempted to launch digital assets. In the last year or so, the number of them being issued in crowdsales called initial coin offerings accelerated to the point that, in 2017, according to data by CoinDesk, $1.5 billion has so far been raised from the crowd — more than twice the $695 million in venture capital funding into blockchain startups.

But one question hovered over these token sales: In the United States, would such offerings be deemed securities?

In July, the Securities and Exchange Commission issued a report stating that some crypto tokens may fit the definition of securities and would therefore be subject to certain investor disclosure and registration requirements. It used what is called the Howey test (more on that below) to define which offerings would be labeled securities.

But the report left many questions unanswered, particularly around what the crypto community has taken to calling “utility tokens” — multidimensional coins which function only partially as a sort of equity in a network, whose value results from a mix of speculation in the asset and the demand for their use in that network. For instance, a token that powers a decentralized storage network, if it’s structured correctly, should grow in value as usage of storage on the network increases. However, unlike company stock, its value wouldn’t derive from any one corporate entity but from all the activity by a variety of actors on this open source network. In contrast to utility tokens, security tokens — coins that, like traditional securities, represent shares in an entity similar to company stock or shares in a limited partnership — don’t have any additional utility beyond representing the value of the fund and the profits would depend on the promoter.

Monday, Marco Santori, one of the most prominent lawyers specializing in blockchains and a partner at Cooley, and Juan Benet and Jesse Clayburgh of Protocol Labs, a startup working on building decentralized open source internet protocols which was behind the biggest ICO so far this year, Filecoin, released a white paper, “The SAFT Project: Toward a Compliant Token Sale Framework,” arguing that most utility tokens are not securities once their blockchain-based networks have been launched, but that coins sold before the network launch are.

Marco Santori, partner at CooleyCourtesy of Marco Santori

“I think almost all pre-functional tokens result in a security per U.S. law,” says Santori, noting that this is a controversial stance in a world in which so many token sales occur before the issuers have launched a network. “Just because utility tokens will one day have a consumptive use, does that remove them from security status prior to that use? On its face, the answer is no.”

To determine how traditional securities regulation applies to tokens, the SEC and other legal minds have used the four-pronged Howey Test, derived from the SEC vs. W.J. Howey Co. case, which states that a security is an investment contract in which a person 1) invests their money 2) in a common enterprise 3) with an expectation of profits 4) based on the efforts of the promoter or a third party. In order to be considered a security, an offering must meet all four prongs.

The fourth prong is the one that prompts the authors to assert that tokens sold pre-network launch are securities while tokens for functional networks are not. They write that this prong “asks ‘whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.’” To answer that question, they say the purchasers of already-functional tokens include two groups: those who wish to use the token (and thus not driven by a profit motive) and speculators who are. However, they argue, citing previous cases involving silver bars, futures contracts for gold coins and a futures contract for sugar, that the profits that speculators expect are not driven by the entity that created the network but the fluctuations in the market. Though they concede that tokens differ from silver, gold and sugar in the sense that the price of the tokens could still be influenced by the developers who launched it, they assert that the “essential” efforts were already exerted prior to the token launch and state, “It would be difficult to argue that any improvement on an already-functional token is an ‘essential’ managerial effort.” In their view, the value of a token would be influenced by a variety of factors, including not just any upgrades performed by the developers but trends in the network’s industry and news events. “For functional utility tokens, mere price appreciation on a secondary market is not a substitute for the essential managerial efforts of others,” they write.

“For a token redeemable for a box of razor blades, once people are using this token to buy razor blades, there are all kinds of things that can affect the price of that token — worker strikes, the price of steel or the fashionability of beards is one light-hearted example,” says Santori. “Is that to say the developers have no effect on the price of a token? No, of course not, that’s not true. When developers develop a token, most continue to update the thing, and sometimes announcements from the issuers will move the price, but is that the undeniably significant efforts? Against all the possible geopolitical business events that could move the market, that becomes just one of many different factors.”

However, they believe that the expectation of profit from pre-functional tokens does depend on the efforts of the promoter or third-party: “The application of the technical and managerial efforts of the seller is likely the predominant factor in the price of a pre-functional utility token until it transitions to being a functional utility token,” they write. (Santori cites some exceptions: tokens that aren’t good for speculation because they, for instance, include an automatic depreciation mechanism for non-use.) Because, pre-network, agreements to buy tokens are securities, the white paper proposes using so-called SAFTs, simple agreements for future tokens, which “provides investors with the right to fully-functional utility tokens, delivered once the network is created and the tokens are functional,” write Benet, Clayburgh and Santori. Protocol Labs introduced SAFTs (which they used for the Filecoin crowdsale) earlier this year along with the announcement of CoinList, and other early-stage crypto investors such as hedge fund Polychain Capital had independently come up with similar contracts based on Y Combinator’s SAFE (simple agreement for future equity).

While some critics might decry the notion that, despite the democratizing opportunity blockchains provide, early-stage returns in crypto assets should be limited to the already-wealthy and perpetuate the forces in society that have fueled the widening of the wealth gap, Santori says SAFT purchasers take on enterprise risk — “the risk that the whole enterprise may fail if the thing never gets developed, and that is what the investor protection laws are for that are administered by the SEC.” However, everyday retail investors purchasing tokens take on product risk, “the risks of a consumer,” he says. “They’re not risking that this will never, ever get developed but that once they get this thing … it doesn’t function the way it’s supposed to function.” For instance, he said, a purchaser of a Tesla risks the engine not working, “but I haven’t bet the entire value of my purchase on the success of Tesla.” If regulators agree that token purchasers take on product risk, then their actions would be governed by consumer protection laws and the FTC or State Attorneys General. Santori says that this setup would still “achieve the policy goals of that distinction between investor and consumer protection. … We find the SAFT framework obeys the letter of the law without just finding legal loopholes. It’s also in harmony with the policy goals driving the letter of the law.”

He also notes that that objection to the fact that the SAFT framework would exclude non-accredited investors “is really an objection to the U.S. securities laws, not the SAFT framework. Don’t shoot the messenger. … If that’s your objection, you should take that up with Uncle Sam — not with us.” (The SEC did not immediately respond to a request for comment.) Also, he adds, “Under the SAFT framework, you can still participate financially in the growth of this network earlier on than you could have had the token been a security. Yeah, you can’t buy Bitcoin at 20 cents under the SAFT framework -- if Satoshi had done a token sale -- but you could probably buy it at $6 and you’d be doing OK.” Conceding that it might be possible to get tokens their own legal regime, he says, “for now, I think this is the best we have.”

Peter Van Valkenburgh, director of research at Coin Center, a blockchain advocacy group, cautions that the SAFT Project is only one way to interpret existing laws and that how securities law will apply to tokens will not be determined until judges rule on individual cases. “We rely on people who pre-sell a distribution of tokens to ultimately build the decentralized network that would deliver the underlying functionality of the token in the long run and that reliance does look like something like the kind of reliance we have on a normal issuer of a security,” he says. “But a similar reliance occurs when someone pre-sells watches on Kickstarter or pre-sells access to a video game universe on Indiegogo. You’re still relying on them to make the product they’re promising, and then the open question with respect to securities laws is, so is this more like a crowdfund for a product to a crowdfund for equity.” And that question would be determined on a case by case basis.

He says this white paper presents a route for projects that don’t want to become the case that defines the law. “The paper represents, what if we don’t want to be the case that proves that we were selling securities? Because then, oh, good, now we have clear law, but oh, bad, I’m the one who helped bring that clarity by virtue of being prosecuted for being an unregistered securities promoter.”

Van Valkenburgh also said that there could be an argument made that even pre-network, many tokens may not be securities. “There are all kinds of useful items sold by a company before they’re produced or developed and they may even be transferrable like game memberships or you could a smart watch campaign and you nay buy a bunch of them because you know there will be a bottleneck in production and you will sell them to your friends. None of those are securities, and if we really do believe the underlying token is a useful item — something that primarily has a consumptive use value or a commercial purchase — then it is something you would in theory be able to sell in advance of its creation,” he says.

Critics such as English lawyer Preston Byrne in the blockchain space who blogs frequently on whether crypto tokens are securities scoff at the notion that a thing could be categorized as a security one day and then no longer be labeled as such the next.“You can’t really call a token one thing today to obtain the benefit of a safe harbor, and then reclassify it as something else tomorrow because you want to trade it,”he wrote in an August blog post.

Santori rebuts that argument by saying, “The SAFT doesn’t become the token. There is no existential metaphysical continuum where this pdf file become an entry on a decentralized ledger. That’s not how the world works. And frankly, that’s not how the Howey test works.”

Coin Center doesn’t hold the same position as the authors of the white paper, because it contends that if something really has consumptive use purposes, they shouldn’tonly be sold to accredited investors. However, Van Valkenburgh finds the SAFT “a reasonable approach to uncertainty” for projects that don’t want to be the guinea pig for how securities law applies to utility tokens. “If you ever want to find someone who’s reasonable, find someone who’s got people who are yelling at them from both ideological spectrums,” he says. “Both the people who are super-anent on everything being treated as a security are yelling at people doing a SAFT and people who are super-intent on nothing being a security if it’s a token say that a SAFT is a bad idea. Maybe if they’re shooting at you, you’re doing something right.”